Sunday, February 9, 2014

Keynes and Sticky Prices: Time to Think Outside the Box

Several recent excellent posts have appeared on Keynesian economics and sticky wages and prices. David Glasner points out that

...the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.

and quoting David again

it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply.

...even if you don’t think wage flexibility would help in our current situation (and like Keynes, I think it wouldn’t), Keynesians still need a sticky-wage story to make the facts consistent with involuntary unemployment. For if wages were flexible, an excess supply of labor should be reflected in ever-falling wages.

Lets look at some facts. In contrast to Simon's assertion; the evidence from the Great Depression is that wages and prices areremarkably flexible. During the first six years of the Great Depression, nominal wages and nominal prices fell by thirty percent. Here is a graph of the normalized CPI and a normalized wage index that I constructed using aggregate data on compensation to employees (the details are in my book Expectations Employment and Prices and you can download the data here)

Of course the fact that the CPI and the wage moved in lock step means that the real wage did not fall and that, I would guess, is the fact that Paul and Simon would point to. But that is very different from there being "overwhelming evidence" in favor of sticky prices.

The new-Keynesians have tried to discipline their models by looking at micro data on the frequency of price changes. Here again; the NK model falls short. Klenow and Malin find that prices in the micro data are simply not rigid enough to explain the aggregate data. Keynesians often cite Truman Bewley's 1999 study as evidence in favor of downwardly rigid nominal wages but a piece by Tomas Hirst (posted over at Pieria by Marco Nappolini) draws our attention to recent work by Elsby Shin and Solon which casts serious doubt on the relevance of Bewley's finding. ESS find, that in the US, the wage data

...show a surprisingly high frequency of nominal wage reductions.

and for the UK,

...like the authors of previous British studies of nominal wage change, [the authors] are struck by the apparent flexibility of British wages.

So lets get back to what's really important. High and persistent unemployment is a problem. But it has nothing to do with inflexible wages or sticky prices. Both Classical AND new-Keynesian models are broken. It's time to think outside the box!

"During the first six years of the Great Depression, nominal wages and nominal prices fell by thirty percent."

Given the severity of the depression, why did they not fall much faster? Share prices and FX rates can rise or fall by 30% or more in a matter of seconds. That's the kind of flexibility required by theories of the sort Lucas and Prescott would have us adopt.

Real wages did not drop as unemployment skyrocketed to over 20% which is pretty definitive proof of the stickiness of real wages. A better explanation of the 1929 to 1935 wage/price index chart is that real wages are highly responsive to inflation/deflation. Confirmation might come from the 1975 to 1984 period when inflation was high and wages moved up rapidly.

RobertA lot depends on what one means by "sticky". Modern new-Keynesians mean that there are 'frictions' that prevent wages and prices moving to clear markets. The 1930s data is a real challenge for that program since any reasonable definition of a friction has counterfactual implications for the micro data. In NK theory; the slope of the Phillips curve is not a free parameter. It is disciplined by micro data. And the micro data suggests that the sole of the Phillips curve should be much much larger than the time series evidence allows.

The problem with standard NK theory is its insistence that the 'natural rate of unemployment' is a meaningful concept. In contrast, my own work which is rooted in search theory, allows for any inflation rate to coincide with any unemployment rate.

I agree that the NK NRU is meaningless unless adjusted for exogenous shocks (oil doubles and employment levels may drop even as inflation skyrockets). Search theory? Do you have a link to a summary?

However, letting micro data refute macro observations is like denying gravity exists because you haven't worked out the GUT yet. Every businessman in the real world will tell you that all prices are sticky (meaning: hard to change faster than inflation/deflation) though they may have a variety of reasons why. If NK theory get into problems with explaining sticky prices then the theory is wrong.

Correction on my previous post: "real wages" in "real wages are highly responsive to inflation/deflation" should be "nominal wages". I am having trouble figuring out how the data does not show that prices are obviously sticky on a nominal and real basis - at least as a business man would define them.

Although I agree that macro does not need to assume a representative agent; there should be a link of some kind to micro foundations. In physics, for example, the gas laws do not model the behavior of individual particles, but the reason is explained using statistical mechanics. Werner Hildenbrand and Jean Michel Grandmont made a lot of progress with a similar idea in economics and that work, in my view, should be revisited.

That said, however, it is the new-Keynesians themselves who insist on disciplining the slope of the Phillips curve with cross-section evidence from micro studies.

As for "obviously sticky"; without a theory to interpret the data; 'stickiness' like beauty, is in the eye of the beholder. While its true that prices and wages do not move in the way that they are predicted to move by classical theory; nor do they move in the way they are predicted to move by new-Keynesian the theory. Hence my call to "think outside the box".

Ben, Kevin and IgnimI think you are all saying pretty much the same thing. My reading of the data, both in the 1930s and now, is that nominal wage and price movements are essentially independent of any measure of excess capacity.

Kevin asks why wages and prices did not move much faster. I think the more salient question is: why didn't wages fall faster than prices? Since the percentage decline in wages was the same as the percentage decline in prices (at least using my wage series) the effect on the effective cost of labor was zero.

A second question, for those who would blame nominal rigidities for mass unemployment is; why did wages and prices start to climb again in 1933 when there was still 20% unemployment?

I agree that rising wages in 1933 are hard to reconcile with Keynes's theory. (But it is even harder to fit them into any Walrasian setup, short of a Casey Mulligan story of workers putting their feet up.)

Have any of you modelers taken into account the change in availability of credit for ordinary people resulting from FHA? Even after WWII the most common credit instrument for ordinary workers was a "layaway" plan. Consumer credit was mostly offered by the stores themselves. In the '50s, if you went on a trip you had to use a "buy now, pay later" plan known as traveler's checks. Now large purchases lock borrowers into long-term contracts. Even for a cell phone. No wonder wages are more sticky now than they may have been in the '30s.

DavidThere is quite a bit of recent work on the importance of credit, particularly the idea that sometimes some people are constrained in how much they can borrow. I don't think that anyone has used that to explain why wages and prices are, according to the new-Keynesians, 'sticky'. The behavior of nominal wages and prices is a logically separate issue in NK models and is used to transmit credit frictions into movements in unemployment (not very successfully in my view).

agreed. Alchian and Woodward’s 1987 ‘Reflections on a theory of the firm’ says:“… the notion of a quickly equilibrating market price is baffling save in a very few markets. Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances? If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears? … But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

Alchian and Woodward explain unemployment to the side effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm contract with one another.

For me the point about wages and prices during the first few years of the Great Depression (at least in the US) is exactly that real wages did not fall. The standard "story" is that declining *real* wages shift the short-run AS curve, thus allowing the economy to return to full employment.

But you're right. Something is seriously wrong with all (almost all?) the stories people are telling based on whatever model they're using.

Would you agree that wages and prices were more variable in the pre-WWII and pre Attlee economies? This would not only because macro-economic policy would be more able to target domestic variables (rather than a fixed exchange rate/gold standard with substantial international capital mobility - the latter factor not being a feature of the Bretton Woods period), but because of a new social contract that emerged during the wartime and Attlee periods?

I would imagine that since the miner:s strike and other events, some price and wage variability may have returned to the labour market, but is there not reason to doubt it would have returned to the levels of the Dickensian, pure capitalist, more "classical English PE" looking economy of the Victorian and even interwar eras?